“The Success Equation” - The Role of Skill & Luck in Investment Decisions

Last month the U.K. Guardian reported that a cat won their year-long stock selection contest against investment professionals and students. While the professionals used their decades of investment knowledge and traditional stock-picking methods, the cat selected stocks by throwing his favorite toy mouse on a grid of numbers allocated to different companies.

The stock contest illustrates the fact that many activities generate outcomes that are a function of both skill and luck. When analyzing specific results in business, sports, and investing it is often difficult to distinguish what share of the outcome was attributable to skill, and what share of the outcome was attributable to luck.

Skill vs. Luck

Addressing the skill versus luck topic, Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management , recently published a book entitled “The Success Equation” (Harvard Business Review Press (2012)). The book examines the various studies on the topic and analyzes the implications for investors. His goal was to use the results of the studies to provide a guide to allow investors to make better decisions.

Focusing on business, sports, and investing, Mauboussin claims that if an activity involves a relatively large portion of luck then short term results will be inconsistent:

“How well you do in the short run doesn't tell you much about your skill because you can do everything right and still fail or you can do everything wrong and succeed. For activities near the luck side of the continuum a good process is the surest path to success in the long run.”

Based on his analysis of historical data he created a luck/skill continuum:

Skill Driven Outcomes

The outcome of a tennis match, Mauboussin claims, is likely to be decided based on skill due to the number of times the players execute their shots. Tennis players hit hundreds of shots during a match. The player with the more skill generally will prevail since the ‘sample size’ – the number of times a player gets to exhibit their skills – is relatively high. Statistically this makes it more likely that the result will favor the one with the better skill set, and increases the odds of the more skilled player winning.

Football teams on the other hand only run a few dozen plays during a game. Scoring is controlled by a half-dozen or fewer skilled players, adding more luck to the mix. The ‘sample size’ is much smaller, therefore it is more likely the more skilled team will lose compared to tennis or chess. Ice hockey players with exceptional skills are on the ice maybe one-third of the game, which leads to outcomes driven by higher degrees of luck according to the studies and statistical data.

Luck Driven Outcomes

In some activities skill takes a back seat to luck. For example when choosing lottery numbers, playing slot machines, or spinning the roulette wheel luck plays a larger role in the outcome. When luck is involved “it is hard to fail on purpose.”

In a recently published note entitled “Investing Forecasts Omit Key Factor – Luck” Financial Times editor James Mackintosh discusses the large role luck plays in stock selection and market forecasting. He notes one-year stock market returns are difficult to forecast because they are a function of luck, driven by chance over such a short period of time:

Over such a short [one-year] period, chance dominates, as the extreme variations of returns suggest. Only just over two-thirds of the time was the one-year real return on world shares between minus 12 and plus 23 per cent in the past 112 years (see chart). Statistically, investors should have little confidence in any base for one-year forecasts.

Investing is also an activity that is highly subject to luck according to Mauboussin – at least in the short term. Longer term the investment process, philosophy, and strategy utilized by the manager will determine if excess returns are being added by the manager’s skillset:

Because investing involves so much luck in the short term it would stand to reason that short term success or failure is not a reliable test of skill. But all of us effortlessly find causes for the effects we see and making money appears to be clear evidence that the investment manager knew what he was doing. Investing is a field where this fallacy is very costly...

Investing is a highly competitive activity which means that randomness plays a large role in determining results. While there is evidence of skill, only a small percentage of investors are skillful and an assessment of their short term results will not reveal their ability....

An investment process and strategy that creates a situation where the odds favor excess returns will, over time, allow investors such as legendary fund manager Bill Miller to outperform the S&P 500 index fifteen years in a row. Mauboussin notes Miller will have periods of underperformance during times of bad luck but longer term will outperform. While short term results may be impacted by adverse luck, skill can be statistically verified with positive longer term investment results.

In situations where luck plays a relatively large role in the outcome (like investing), Mauboussin claims the decision making process becomes more important than the short term result:

In other words in a pursuit such as blackjack where luck is very important, you have to adopt a process that you can trust and not worry so much about the outcome of each hand or even each session of play. Your only chance of winning is to adhere to the rules that you know work....

Which led Fortune magazine to summarize the findings of Mauboussin’s studies as follows:

The best investors (and gamblers) focus on good process as much or more than on the good outcome.

Reversion to the Mean

“Any time luck contributes to outcomes”, such as with investing, “you will have reversion to the mean” according to Mauboussin. If the results of an activity are solely attributable to skill he notes the statistics should not show the attribute of mean reversion.

Testing the thesis that investment returns are driven by luck in the short term Mauboussin examined historical returns of U.S. mutual funds. Market data indicates the correlation between excess returns in a three year period and the next is negative, at least when examining the 1,500 mutual funds in Mauboussin’s database. He claims this is indicative of a reversion to the mean situation which indicates a relatively high degree of luck is involved in portfolio management.

Looking back at the portfolios of some of the great investors like Charles Munger, Edward Thorpe, and even the stock of Berkshire Hathaway back in the 1970’s (when the company was a microcap), the performance of each tended to revert to the mean after a period of underperformance.

Improving Skill and Luck

Mauboussin also discussed improving the decision making process to enhance both skill and luck. He claims accurate feedback is essential no matter where one is positioned on the luck/skill continuum, but the individual needs to be aware if the feedback is primarily a function of luck or skill.

Improving a person’s skill or luck means constantly looking for ways to change behavior for the better – “either because what you're doing is wrong, or because there's a slightly better way of doing it. This is true whether you are a basketball player shooting free throws, a doctor performing surgery, and executive making acquisitions, or an investor buying stocks.”

Skill can be improved by a process described as ‘deliberate practice’. This involves hours of concentrated and dedicated repetition to improve a specific skill. Skill shines through only if there are a sufficient number of repeated outcomes from the activity to weed out bad luck.

For investors, due to the degree of luck involved, the focus should be on improving the investment decision making process and strategy according to Mauboussin – essentially the investor refines the investment process to ‘make their own luck.’

Studying some of the great investors – Warren Buffett, Charlie Munger, John Maynard Keynes, Edward Thorpe – it appears that all refined the investment process to maximize their returns over time. All of these investors ultimately used some form of the ‘Kelly formula’, a strategy where an investor who finds a situation where they have an edge places ‘proportional bets’ based on their analysis of the applicable risks and rewards.

When a large positive outcome has a high probability of occurring the Kelly formula provides the investor bets (invests) heavily. When the odds are not heavily tilted in the investor’s favor the individual should scale back the size of the investment, or not invest at all.

One of the downsides of using the Kelly formula is that it will generate a higher degree of volatility than normal since the investments will tend to be concentrated on those situations there are favorable risk/reward opportunities. Concentration tends to increase portfolio volatility.

While the market has evolved since the days of Keynes, Buffett, Munger and Thorpe, Mauboussin claims that historical market data indicates a focus on improving the investment process should allow a manager to generate similar long term excess returns in today’s markets.